Wai-Man Liu and Phong Ngo
Elections, political competition and failure
Journal of Financial Economics | Volume 112, Issue 2 (May 2014), 251-268
In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks
Rep. Spencer Bachus — chairman of the House Financial Services Committee in the 112th Congress, The Birmingham News on 8 December 2010.

 

The relationship between banking and politics is an intimate one. Governments control the supply of banks in the economy through chartering restrictions and licensing, they set up institutions that provide depositors with insurance and banks with a lender of last resort, and routinely set rules that attempt to govern the risk taking behaviour of banks.

Indeed, the bi-annual “Banking Banana Skins” survey by Pricewaterhouse Coopers and the Centre for the Study of Financial Innovation finds that “political interference” was rated as the number one risk that banks faced in 2010. This is surprising given the international banking system had witnessed possibly the worst crisis on record which was largely attributed to credit and liquidity risks, and at the same time, ironic, given the banks were bailed out by politicians using public money.

This active role of government in the banking sector creates an incentive problem. On the one hand, government play a role in the creation of institutions that make a banking system possible. On the other hand they quite often look to the banking system to facilitate their own political survival. Political support can be indirect, through say, subsidized lending to preferred industries or direct in the form of campaign contributions or a share of profits due to ownership. For example, according to the Centre for Responsive Politics, Spencer Bachus, who is the chairman of the House Financial Services Committee in the 112th Congress, raised over $2.3 million in campaign funds in 2011-2012 with the top five industries being commercial banks, securities and investment, insurance, real estate and finance/credit companies contributing over 40%.

So while a healthy banking system can be huge source of benefit for politicians, bank failure on the other hand, can get politicians into electoral hot water. Politicians therefore have incentives to interfere with bank closure rules to, for example, favour preferred (politically connected) constituents or simply to avoid the political costs associated with failure.

Examples of Political Interference

There have been several examples in the popular press of political interference in the banking system. Probably the most famous case is that of Lincoln Savings and Loans, in which five US senators (known as the “Keating Five”) were accused of improperly intervening in a regulatory investigation of Charles H. Keating, Jr. (Chairman of the Lincoln Savings and Loan Association) by the Federal Home Loan Bank Board (FHLBB) in 1987. Lincoln Savings and Loans eventually collapsed in 1989, at a cost of over $3 billion to the federal government. The substantial political contributions Keating had made to each of the senators, totalling $1.3 million, attracted considerable public and media attention. This lead to a Senate Ethics Committee investigation in which three of the senators were found to have “substantially and improperly interfered with the FHLBB's investigation” and the other two, while being cleared, were criticized for exercising “poor judgement”. All five senators served out their terms however only the two ran for re-election.

A more recent example is that of Cleveland thrift AmTrust, whose failure was delayed by 11 months because Ohio Congressman Steven LaTourette and Cleveland mayor Frank Jackson intervened when the Federal Deposit Insurance Corporation (FDIC) tried to seize and sell the institution in January 2009. AmTrust was issued with a cease and desist order in November 2008, and when it failed to recapitalise by the deadline of December 31, 2008 the FDIC stepped in. The local politicians were able to delay the failure by convincing Treasury and the White House to keep the FDIC at bay. By the time AmTrust was finally seized by the FDIC on December 4, 2009 its common equity had fallen by $667 million to $276 million from the year before. The failure cost the FDIC insurance fund $2 billion.

Is political interference systematic?

Are these incidents isolated cases? Just a few “bad eggs”—or are they representative of a more systematic phenomenon? A natural place to look for systematic evidence of political interference in banking is around elections as this is when bank failure can potentially be the most costly to a politician. Bank failure typically leads to costs that are borne by the taxpayer (for example, due to losses to the insurance fund), leading the electorate to question the competency of the incumbent in regulating the banking sector. Accordingly, politicians have the incentive to take costly action to delay bank failure in election years. The economic cost of delay (possibly from larger losses to the insurance fund than would otherwise be the case) is widespread across tax payers, whereas the benefits are concentrated with interest groups like bank owners, employees and uninsured depositors—which further exacerbate the political incentive to delay bank failure in an election year.

Bank failures probability before elections

Using data from the United States between 1934 and 2012, covering all failed banks (3995) documented by the FDIC, we study the timing of bank failure around gubernatorial elections (state elections for the office of governor). In the figure below, the blue bars plot the number of bank failures in 3-month blocks leading up to an election while the pink bars plot the number of bank failures in 3-month blocks in the months after state elections. The blue and pink horizontal dashed lines represent the average number of bank failure in a 3-month period before and after elections respectively.

While Figure 1a shows no discernible difference between the pre- and post-election failure rates (235 vs. 240 failures per 3-months respectively), a striking picture emerges when we control for the clustering of bank failure around crises: bank failure is much less likely in the months leading up to an election than in the months after. In fact, based on these raw numbers alone, bank failure is about 40% less likely in the months leading up to an election compared to the months following an election-the pre- and post-election average number of bank failures are 59 and 97 failures per three-months respectively.

1: Bank Failure around Gubernatorial Elections
liu-ngo-1a

 

liu-ngo-1b
The figure below plots the frequency of bank failures around gubernatorial elections for all recorded failures (3995) of FDIC insured financial institutions (commercial banks and thrifts) between 1934 and 2012. Panel (a) plots bank failures in all periods. Panel (b) plots banks fails in non-crisis periods only, i.e. failures occurring during the S&L Crisis (1986-1992) and the Global Financial Crisis (2007-2010) are excluded.

In Figure 1, we have used the term `bank failure' to mean both outright failures in which banks lose their charter and cease to operate as well as FDIC assistance transactions in which a failing institution is restructured with FDIC assistance and allowed to continue to operate under its existing charter. To examine whether political concerns determine the type of failure transaction chosen by regulators around elections we split all failures into two sub samples depending on the failure type. In Figure 2 we plot the frequency of bank failures around elections separately for outright failures (Figure 2a) and assistance transactions (Figure 2b).

2: Election cycles and bank failure - by type of failure
liu-ngo-2a

 

liu-ngo-2b
The figure below plots the frequency of bank failures around gubernatorial elections for all recorded failures of FDIC insured financial institutions (commercial banks and thrifts) between 1934 and 2012 in non-crisis periods only, i.e. failures occurring during the S&L Crisis (1986-1992) and the Global Financial Crisis (2007-2010) are excluded. Panel (a) plots the frequency of outright bank failures. Panel (b) plots bank failures that are classified as assistance transactions.

Like Figure 1, the blue bars plot the number of failures in 3-month blocks leading up to an election while the pink bars plot the number of failures in 3-month blocks in the months after elections. The blue and pink horizontal dashed lines represent the average number of bank failures in a 3-month period before and after elections respectively. There is a remarkable difference between the two figures: outright failures are clearly less frequent prior to elections whereas assistance is much more frequent-politicians tend to bailout banks or delay the failure of banks due to electoral concerns.

Keeping bankrupt banks open increases losses

So what can be learned from this? First, political interference in efficient bank failure can lead to larger losses than would have otherwise been the case: allowing banks with zero or negative net worth to continue to operate allows them to “gamble for resurrection” by taking on excessive risk. Second, if banks know that they are likely to be bailed out due to political concerns, this might encourage them to take on more risk-the standard moral hazard problem, though now it does not only apply to banks that are “too big to fail”, but potentially any bank if it is an election year. Both imply that ex-post bank closure rules play an important role in determining ex-ante bank risk taking.

However, since the global financial crisis, regulators around the world have been “fixing” bank regulation by introducing new capital and liquidity requirements for banks while, for the most part, ignoring the important role of bank closure policy.

Regulators should be independent

In closing, we have some good news and some bad news:


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